Earnings: The Indispensable Element Of Great Stocks

Watching For Pitfalls

Investors can easily be misled by popular myths about
earnings.

Myth: You should buy stocks
with low price-to-earnings (P-E) ratios.

The P-E ratio is a comparison of the stock's price
to its annual earnings per share. For example, a stock
quoted at $50 a share with annual earnings of $5 per
share has a P-E ratio of 10. In other words, the stock
is selling at 10 times its annual earnings.

Conventional wisdom says stocks with higher P-E ratios
are overpriced and should be avoided. But the truth
is that the best stocks often have high — some
would say ridiculous — P-E ratios when they start
their big climbs. And they continue having high P-Es
throughout their advances.

Studies prove the percentage gain in earnings per share
over the year-earlier period had a greater impact on
a stock's price.

Would you have purchased these "high" P/E
stocks?

Stock

P/E Ratio before advance

Amgen

300

(Up 650% in 22 months starting March 1990)

America Online

205

(Up 557% in six months starting October 1998)

Mindspring

157

(Up 237% in five months starting November 1998)

Ascend Communications

49

(Up 1,380% in 15 months starting August 1994)

MCI Communications

42

(Up 266% in 17 months starting April 1988)

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If you weren't willing to pay the higher P-Es, you
eliminated some of the best stocks of all time.

Myth: It's better to get into
an unprofitable company's stock before the company
turns around and other investors discover it.

Again, studies tell you established companies that
can't make much money for themselves can't make much
money for investors. Even in late 1990s, when it seemed
any stock with a dot-com name could surge without the
slightest hint of profitability, a track record of good
earnings growth still won the day. Research has shown
most Internet stocks with earnings growth outperformed
their counterparts posting losses.